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Is Your Business an “Inactive Entity” Under the CTA?

Is Your Business an Inactive Entity Under the CTA

By: Ted Sutton, Esq.


Sam was a young man who began buying stocks at a young age. As he got older, his stock portfolio kept growing. But because he held the stocks in his personal name, Sam was concerned about the portfolio being exposed in a lawsuit. In order to protect his investments, Sam formed a Wyoming LLC in 2021.

Sam’s best friend was Ricardo, a Spanish citizen whom he met in college. Ricardo also loved to invest in stocks, and wanted to invest alongside Sam. So in 2023, Sam gave Ricardo a 30% interest in the Wyoming LLC. Ricardo contributed $5,000 worth of stocks into the LLC.

From that point on, it was all downhill for Sam and Ricardo. The Corporate Transparency Act (CTA) took effect in 2024. And because Sam and Ricardo didn’t timely report their Wyoming LLC, they were hit with a $10,000 fine.

What Are Inactive Entities?

Under the new CTA, companies are required to report information about their business and its “beneficial owners” to the Financial Crimes and Enforcement Network (FinCEN) at the U.S. Department of the Treasury. However, the CTA carves out 23 exemptions for certain entities.

One of these exemptions is the “inactive entities” exemption. Many business owners may try to argue that their company meets this exemption. But the exemption’s requirements are a lot stricter than you think.

“Inactive entities” are entities that:

  • Were in existence before January 1st, 2020.
  • Are not engaged in active business
  • Have no ownership held by a foreign person
  • Have had no change in ownership in the last 12-month period
  • Have not sent or received funds over $1,000 within 12-month period; and
  • Do not hold any type of assets

Your business must meet all of these requirements to be classified under the “inactive entities” exemption. And if it doesn’t, it must report information to FinCEN.


As you can see, Sam’s Wyoming LLC failed all of the requirements. Sam created the entity in 2021. Ricardo, a Spanish citizen, acquired an interest in the Wyoming LLC within the past year and placed $5,000 worth of stocks into it. And, of course, the LLC owned assets in the form of stocks.

The only argument that Sam could make here is that the LLC was not engaged in any “active business.” But because the Wyoming LLC failed every other prong, it does not meet all of the “inactive entity” requirements. As such, it needed to report its information to FinCEN.

Beneficial Ownership Requirements

Another thing worth mentioning is the beneficial ownership requirements. A “beneficial owner” is someone who owns at least 25% of the company, or someone who exercises “substantial control” of the company. If someone meets the requirements of a “beneficial owner,” they must report their beneficial ownership information to FinCEN.

In the example above, Sam owned 70% and Ricardo owned 30% of the Wyoming LLC. Because both owned greater than 25%, they both qualify as “beneficial owners.” As such, both must report their beneficial ownership information, including copies of a passport or driver’s license, to FinCEN.


The CTA is a new law that nobody is talking about. It is complex and convoluted. Even worse, many business owners will be left in the dark about the law and its requirements.

Luckily, we here at Corporate Direct will help you navigate the CTA. For more information, click the link here.


Corporate Direct has a weekly YouTube segment called Direct Answers from Corporate Direct

In this segment, we educate people on corporate law, business formation, real estate, wealth building, and asset protection. And if you have any general questions about something, please feel free to leave a comment on one of our videos!

For more of these updates, click the link below and subscribe to our YouTube channel.

Texas: The New Hotbed For Business?

Texas: The New Hotbed For Business?

By: Ted Sutton, Esq.


In the business realm, Texas has become the lone star that is burning brighter. And it may become a top state for business in the near future.


They say that everything’s larger in Texas. This also includes a larger demand to form a business in the Lone Star State. Forming a business in Texas has become a popular alternative to other larger states like California and New York. Given its thriving economy and a favorable tax climate, Texas has seen an increase in new LLC formations.


These formations may increase further. Under the recently-passed Senate Bill 2314, Texas now recognizes the charging order as the exclusive remedy for both single-member and multi-member LLCs.


The charging order apples when an LLC member is personally sued and loses in court. But in order for the lawsuit winner to collect anything from the LLC, they must wait until any distributions are made from it. So, if no distributions are made, then the winner doesn’t collect anything from the LLC. This is true, even if the loser is the only member of the LLC. This new law takes effect on September 1, 2023.


This new law overrules Devoll v. Demonbreaun, a 2016 Texas Court of Appeals case[1]. Devoll held that the charging order was not the exclusive remedy, even if it was charged against an LLC’s membership interest. This new Senate Bill changes this outcome. Now Texas LLC owners are better protected in the event they are personally sued.


On top of this, Texas has also just formed the Texas Business Court. Similar to the Delaware Court of Chancery, this new court system will handle corporate disputes and complex litigation matters. Texas will eventually set up these courts in Austin, Dallas, Fort Worth, Houston, and San Antonio. This court will help expedite lawsuits and provide case law to resolve these disputes. But most importantly, this will attract even more business to the state. These new courts are set to start on September 1, 2024.


Another thing Texas has is its large population and rapid population growth. Currently, Texas is the second largest state with 30 million people. And since 2010, Texas has had the third-fastest growth of any state at a whopping 20%. Given these recent trends, it could take that top spot in the not-too-distant future.


Could Texas overtake Delaware and Wyoming as the best state for businesses? Only time will tell. However, these recent developments show that it may be possible.


[1] Devoll v. Demonbreun, No. 04-14-00331-CV (Tex. App. Aug. 31, 2016).



Corporate Direct has a weekly YouTube segment called Direct Answers from Corporate Direct

In this segment, we educate people on corporate law, business formation, real estate, wealth building, and asset protection. And if you have any general questions about something, please feel free to leave a comment on one of our videos!

For more of these updates, click the link below and subscribe to our YouTube channel.

Five Reasons Why We Don’t Recommend DAO LLCs

We Don't Recommend DAO LLCs

By: Ted Sutton, Esq.

Over the last few years, the use of blockchain technology has exploded onto the scene. DAOs have grown in popularity alongside it.

So, what exactly is a DAO? A DAO is a new entity form that stands for Decentralized Autonomous Organization. What’s unique about them is how they can be managed. Like other entities, individual members can manage DAOs. What makes them different is that they can also be managed by a smart contract on the blockchain ledger. This new and unique form of management has encouraged people to form them as partnerships, which offer no protection. Because of this, a better vehicle was needed.

In response to this demand, some states have already enacted new laws. Wyoming has passed legislation allowing for DAOs to be formed as “DAO LLCs.” Tennessee has passed a similar law allowing for Decentralized Organizations, or “DO’s.” These entities can be formed with the Secretary of State and provide the same asset protection as LLCs. Utah also passed a similar act that allows for the creation of “limited liability decentralized autonomous organizations,” or “LLDs” for short.

Proponents say that this smart contract management makes the DAO easier to be managed remotely, more efficient to govern, and removes any management conflicts between humans. While these things may be true, there are five reasons why we here at Corporate Direct do not recommend forming DAOs for our clients.

    1. The Smart Contract is open-sourced

The first reason is that the smart contract is available for public view. Because the smart contract is on the blockchain ledger, anyone can see how your DAO is being managed. On top of this, the Wyoming Secretary of State requires DAO applicants to include the smart contract’s public identifier when forming the DAO LLC. So anyone can see your LLC’s roadmap. Do you want the world knowing how you distribute profits? Unlike a DAO’s smart contract, an LLC’s operating agreement or a Corporation’s bylaws are not available for public view. Every other entity provides this type of privacy. DAOs do not, which is why we stay away from them.

    1. The DAOs can still be hacked

Second, DAOs can still be hacked, even with a smart contract in place. This happened in the California case of Sarcuni v. bZx DAO. In Sarcuni, people deposited digital tokens into the bZx DAO in exchange for membership interests. Over time, the DAO accumulated over $50 million worth of these tokens.

One day, one of the members received a phishing email from a hacker. After the member opened the email, the hacker was able to access the member’s private key and take $55 million worth of funds from the DAO. One would think that the DAO’s smart contract would have stopped this transfer. But that was not the case. In fact, the DAO had lost $9 million in three previous hacks.

On top of this, the court also found that because the DAO is not a recognized entity type under California law, DAO’s are treated as general partnerships. This means that if the DAO is sued, each of its members are personally on the hook for any liability. Was anyone sued personally for the loss of $64 million in the Sarcuni case? Under California law, they could be.

Given the recent rise in computer scams, any business can be a victim to them. But because DAOs with smart contracts face these same risks, they are a much less appealing option. Even worse, if your state doesn’t recognize DAOs, any member is individually liable for any claims brought after the DAO has been hacked.

    1. The law still applies to DAOs and their owners

We also don’t recommend the DAO since they may still be subject to other regulatory requirements, even when its owners try to avoid them. This happened in the case of Commodity Futures Trading Commission v. Ooki DAO. In Ooki, BZero X LLC operated a trading platform where people would exchange virtual currencies on the blockchain network. In an attempt to avoid regulatory oversight from the CFTC, BZeroX transferred their protocol into the Ooki DAO. After this move, the CFTC filed suit against Ooki.

The court found that because the DAO traded commodities, the DAO was subject to regulation under the Commodity Exchange Act (CEA). On top of this, the court found that under the CEA, DAOs are treated as unincorporated associations. Like general partnerships, this also means that Ooki’s members are subject to personal liability.

While people may think that they can use DAOs as a conduit to avoid the law, they are sorely mistaken. You are much better off using a traditional LLC.

    1. DAO owners can be personally liable if the DAO is sued

In states that do not have DAO legislation on the books, DAO owners can be personally liable if the DAO gets sued.

The Sarcuni court found that DAOs are treated like general partnerships. In addition, the Ooki court found that DAOs are treated like unincorporated associations under California and Federal law. In both of these cases, after the DAO was sued, all of its owners were personally liable for any judgment entered against each DAO.

From a liability standpoint, this is disastrous for every DAO member. However, members of properly formed LLCs and Corporations do not have to face this issue. If those entities are sued, their owner’s liability is limited to their capital contributions. Not so in states that don’t recognize the DAO as its own entity.

    1. There is too much legal uncertainty with DAOs

The fifth and final reason for DAO avoidance is that there is too much legal uncertainty associated with them. Only three states have DAO laws on the books. Because of this, there are neither enough regulations nor enough case law to regard DAOs as a safe entity to recommend to our clients.

There are simply too many unknowns at this point in time. And we don’t want our clients to be the test cases.


There is a chance that some of these things may change in the future. Additional states could pass legislation that treat DAOs like LLCs with their own liability protections. Smart contracts could do a better job of stopping hackers. Lawmakers and agencies may also enact clearer regulations regarding DAOs. But because people face these issues when forming DAOs now, we do not recommend them for our clients.

Corporate Direct has a weekly YouTube segment called Direct Answers from Corporate Direct

In this segment, we educate people on corporate law, business formation, real estate, wealth building, and asset protection. And if you have any general questions about something, please feel free to leave a comment on one of our videos!

For more of these updates, click the link below and subscribe to our YouTube channel.

AI May Be Infringing On Your Copyrights

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By: Ted Sutton, Esq.


Many people have used AI to generate new artworks. A few of them can generate an image. And as we saw with the artificial hit “Heart on My Sleeve” meant to sound like Drake and The Weeknd, AI can also generate new songs.  But if you make these new works, you could face liability.

AI stands for artificial intelligence. This intelligence simulates that of humans, as it teaches machines to learn, perform tasks, and make decisions. Hot new search engines such as ChatGPT and Google Bard are forms of AI.

Other AI programs such as Midjourney and Stable Diffusion generate paintings. Users can input text describing the painting they want, and the programs will generate a painting for them. While you may love the final painting, you may hate the fact that you could be sued for copyright infringement.

What is a Copyright?

A copyright is any expressive work of art made by someone. These works can include books, movies, songs, paintings, and even sculptures. People who make these works can register them with the Copyright Office to obtain copyright protection.

What is Copyright Infringement?

A person can infringe on another’s copyright if they either reproduce the work, or make a similar work without the copyright owner’s permission. With people, infringement is more straightforward. But when AI infringes on others copyrights, the issue is much more complicated.

AI can infringe on other’s copyrights in two ways.

AI Training Process

The first way AI can infringe on copyrights is through its training process. All new forms of AI are trained to create new expressive works that could be copyrightable. But in order to train the AI to do this, its programmers need to show it large amounts of data from the internet. Some of this data, however, is copyrighted.

AI Outputs

The second way AI can infringe on copyrights is by the output. When a user enters text into an AI program, the output, or the final product, may be very similar to an already copyrighted work.

Is it Infringement?

Under current US case law, a copyright holder can show copyright infringement by proving two things:

  1. That the infringer has access to the copyrighted work; and
  2. That the infringer’s work was “substantially similar” to the copyrighted work.

Let’s use “Heart on My Sleeve” as an example here. Before generating the song, the AI that made it certainly had access to copyrighted works by both Drake and the Weeknd. How else would the voices in the song sound exactly like them?

Also, while you could make the argument that “Heart on My Sleeve” was a different song, it’s still obvious that it sounds “substantially similar” to anything Drake or The Weeknd produces.

Because of this, either the AI user or the AI company could be liable for copyright infringement.

Does the AI have a defense?

One defense that AI companies can assert is the fair use defense to copyright infringement. If an infringer copies the copyrighted work and uses it as a “fair use,” that infringer will be protected. Fair use of a copyrighted work can include criticisms, commentary, satire, news reporting, and teaching.

But does using copyrighted work in the AI training process, or creating an output that is similar to a copyrighted work, constitute a fair use?

Courts look at 4 factors to determine if a use is fair:

  1. The purpose and character of the use, including whether the use is of a commercial nature or is for nonprofit educational purposes;
  2. The nature of the copyrighted work;
  3. The amount and substantiality of the portion used in relation to the copyrighted work as a whole; and
  4. The effect of the use upon the potential market for or value of the copyrighted work

We’ll use “Heart on My Sleeve” again.

For the first factor, if the use is more commercial in nature, it will likely not be fair use. It is highly unlikely that the use would be for educational purposes. Plus, the person who posted the song made several thousand dollars after its release. So, under the first factor, “Heart on My Sleeve” is likely not a fair use.

For the second factor, if the nature of the copyrighted work was creative or imaginative, then the infringing work is likely not a fair use. Clearly, because Drake and the Weeknd’s are world famous artists, their copyrighted works are creative. Because of this, “Heart on My Sleeve” is likely not a fair use under the second factor.

The third factor, however, isn’t as clear. An AI company could argue that because the AI looked at many different songs, “Heart on My Sleeve” took a small and insubstantial amount from Drake and the Weeknd’s copyrighted works. Because of this, the third factor could constitute fair use.

The fourth factor focuses on the economic effect of the infringing work. If the infringing work would cause economic harm to Drake and the Weeknd, then the work likely would not be a fair use. As described before, “Heart on My Sleeve” made thousands of dollars. That is money that could have gone to Drake and the Weeknd. Because of this, “Heart on My Sleeve” is likely not fair use under the fourth factor.

Drake and The Weeknd could claim that the AI-generated “Heart on My Sleeve” is not fair use. However, a court could rule either way under this untested area of copyright law.

Who owns the Copyright?

Another question is if a copyright owner sues for copyright infringement, who is the rightful owner of the copyright?

Copyright owners are usually the “authors” of the copyrighted work. But when a user generates a work by using AI, it is unclear who the true “author” of the copyrighted work is. Is it the person who entered the text? Or is it the AI software that was both trained to and actually generated the image?

Another question to ask: who should you sue for copyright infringement? The AI company, or the person who used the AI?

Also, would it be fair to hold the user liable? They didn’t know what the final product would look like. And they certainly didn’t train the AI by using other people’s copyrights.


Some people have already filed lawsuits against AI companies. Getty Images has already filed a lawsuit against Stable Diffusion. Getty alleges that Stable Diffusion improperly used their photos to train its AI, in violation of the copyrights that Getty holds.

Individuals have also filed suit against these AI companies. Last year, a group of artists sued several AI companies. They allege that the AI companies both improperly used their photos to train the AI, and that the AI’s outputted photos are substantially similar to their own works.

Because AI brings a new set of untested issues to copyright law, it is unclear who the court would rule for.


As of right now, there are far more questions than there are answers. But in order to have these much-needed answers, we will need several things to happen.

First and foremost, Congress needs to act as soon as possible. They need to determine who owns the copyright to AI-generated works, who authored the work, and when exactly does an AI-generated work infringe on another’s copyrighted work? If they don’t, then there’s a good chance that innocent people who use the AI could be sued for copyright infringement.

To protect themselves from these lawsuits, AI users will need to demand more from the AI companies. Before using their services, companies should inform users that they have permission to both use copyrighted works in their training data and the outputted result. This will ensure that innocent users will not be sued by copyright owners.

But before they can do this, AI companies will need to get permission from the copyright holders themselves. These companies will not only need to obtain the consent of copyright owners, they will also need to compensate them. It is only fair for copyright owners to receive a payment if they agree to have the AI use their works.

Copyright holders should also do their due diligence. They should be on the lookout to see if AI companies are using their works. If they do, they should demand compensation.

Lastly, insurance companies and third-party vendors should demand from AI companies that they are licensed to use others works. This will help protect all parties from liability if a copyright infringement suit is brought.


AI is changing the world at a rapid pace. Some of that change may be welcomed. However, this changed is certainly not welcomed by copyright owners. We need to act fast to address these issues. If not, innocent people could be liable through no fault of their own.




Why Some Licensed Professionals in California Can Form an LLC, But Most Cannot

Why Some Licensed Professionals in California Can Form an LLC, But Most Cannot

By: Ted Sutton, Esq.

Mike has worked as an attorney at a large San Francisco law firm for five years. After graduating law school and passing the California bar exam, he was hired as an associate at the firm. Like many others in Mike’s position, he regularly worked 90-hour work weeks with little vacation time. This workload has led to a whole host of health-related issues, including anxiety and sleep deprivation. Overwhelmed with what he had gone through over the last five years, Mike decided it was time to make a change. He took a leap of faith and decided to become a solo practitioner. This would give him the freedom to set his own hours, control his workload, and improve his overall wellbeing.


The first step for Mike was to determine what type of entity to form. At first, Mike thought that he would be fine forming an LLC for his practice. However, after doing some research, he discovered that California only allows for attorneys to practice under professional corporations and limited liability partnerships. Mike, along with many other licensed professionals in California, are not allowed to form an LLC for their business.


As a general matter, if your job requires a license and/or you render professional services, you cannot form an LLC for your line of work in California. The California Corporations Code provides very few exceptions to this rule, most notably for contractors. This short list is as follows:

Licensed Professionals Allowed to Form an LLC in California:

  • Alarm companies
  • Alcoholic beverage licensees
  • Cemetery authority
  • Contractor
  • Foreign labor contractors
  • Gambling enterprise owners
  • Home improvement salespersons
  • Horse racing track operators
  • Outdoor advertising
  • Private investigators
  • Seller of travel
  • Surplus medication collection and distribution intermediaries

But because most licensed professions do not fall under this list, you are much better off forming a professional corporation at the beginning.


California has a few requirements to properly form a professional corporation. First, the articles of incorporation must clearly state that the corporation is a professional corporation. Second, all shareholders, directors, and officers must be licensed professionals in California. However, the corporation may employ non-licensed professionals.


Mike is happy that he did his research. After learning of California’s restrictions, he properly formed a professional corporation, indicating such in the articles of incorporation. He was the only shareholder, director, and officer because he is the only one in the business that is licensed to practice law in California. He also planned on hiring one paralegal and one secretary to assist him, neither of whom would serve as shareholders, directors, or officers. Mike has checked all the boxes. He can now practice law on his own terms under his newly formed professional corporation.


Professional corporations are also subject to the same rules that apply to other corporations. They must obtain an EIN from the IRS, maintain corporate records, and file annual reports with the California Secretary of State. A professional corporation can be taxed either as an S Corporation or a C Corporation. Because Mike’s CPA suggested using an S Corporation to help minimize payroll taxes, Mike, like most other professionals, chose the S Corporation. Other laws relating to the practice of each licensed profession may also apply to each professional corporation.


It is also worth mentioning that California also allows some licensed professionals, including lawyers, accountants, and engineers, to practice through a limited liability partnership. But because Mike is a solo practitioner and has no other partners, he will have to form a professional corporation.


If you are a licensed professional in California, be aware that you most likely will not be able to form an LLC for your practice. To properly form your professional corporation in California, we here at Corporate Direct will be happy to assist you.


Commingling Funds – Why you should NEVER do it

Commingling Funds Why you should NEVER do it

    By Ted Sutton, Esq.

Ryan was always ambitious and hard working. As a teen, he would regularly work on house flips with his dad. But when Ryan turned 18, he decided to start his own house flipping business.


After listening to his dad’s advice, Ryan formed an LLC for his house flipping business. A service helped him form an LLC with the Secretary of State, provide a registered agent address, and draft an operating agreement for his business. Once he began flipping houses, Ryan held himself out as the manager of the LLC.


But he skipped the step of forming a separate bank account. His dad never used one, so he didn’t feel the need to set one up. Any business funds were deposited and paid out from Ryan’s personal bank account. This was the same account Ryan used to pay his rent and other personal expenses.


After Ryan had been flipping homes for one year, one of his home buyers tripped and fell on a broken staircase. The buyer then filed suit against the LLC. After a lengthy trial, the court found that the LLC was liable for the buyer’s injuries. But because the LLC did not have a separate bank account, the buyer was able to reach Ryan’s personal bank account.


Because Ryan commingled business and personal funds, he was personally on the hook. He could not use the corporate veil to shield himself from personal liability.


What is Commingling Funds?


When you form a business, you can NEVER commingle funds. But what exactly does it mean to commingle funds?


A person commingles funds when they mix business and personal funds into a single bank account. But if you do this as a business owner, you can run into a lot of trouble.


When someone sues your business, a plaintiff may try to pierce the corporate veil to hold you personally liable. The corporate veil itself symbolizes that you are keeping your business property separate from your personal property.


But if you follow the list of corporate formalities, you can stop someone from piercing the corporate veil. The list varies by state, but it may include the following:


    1. Properly formed under the Secretary of State
    2. Maintaining separate bank accounts
    3. Maintaining separate records
    4. Having an operating agreement or bylaws
    5. Having bank accounts that are adequately capitalized
    6. Holding company out as a separate business
    7. Holding yourself out as manager of that business
    8. Conducting regular meetings
    9. Having minutes of those meetings
    10. Following other rules and regulations
    11. Legal entity separate from its owners
    12. No commingling of funds
    13. No personal obligations from business bank account
    14. No evidence of fraud or injustice
    15. Maintain annual filings, annual report, fees, good standing
    16. Having a registered agent
    17. Paying taxes for corporation
    18. Filing separate tax returns
    19. Making proper distributions
    20. Selling interests with proper approval
    21. Issuance of stock or membership certificates


If you follow most of these formalities, there will be a sufficient separation between you and your business. If this separation exists, you will not be held personally liable. But if there is no separation, then you are individually on the hook for any judgment entered against you. For more information on the corporate formalities, please check out my dad’s most recent book, Veil Not Fail.


In many states, the first formality that courts look at in veil piercing cases is whether the business owner commingled personal and business assets. You do not want this to work against you. If you don’t follow this first formality, it is very easy for the court to pierce the veil. But if you form a separate bank account that keeps your business assets separate from your personal ones, the veil will be much more difficult to pierce.


After you get an EIN number from the IRS, opening a business bank account at the beginning is very easy. In fact, many banks have low minimum balance requirements for business bank accounts. Having this separate account will protect you in the long run because it may shield you from personal liability.


Is it commingling or not?


It is also worth mentioning what constitutes commingling funds and what does not. Knowing these differences will help you properly operate your business.


One thing that does not constitute commingling is having bank statements mailed to your personal residence or a P.O. Box. This is especially true if your business is a passive holding company. If your business does not have a physical address, your personal residence may be the only address where banks can send bank statements. Another thing that does not constitute commingling is using your business bank account for all business income and expenses.


However, there are some things that do constitute commingling. Clearly, one of them is using one bank account for both business and personal expenses. Another is using your business bank account for any personal expenses, and vice versa. But if you keep these things separate, you will not be commingling funds.


Is Commingling
Is Not Commingling
- Using one bank account for business and personal expenses
- Sending bank statements to your - personal residence
- Loaning business funds to business owners for personal expenses
- Sending bank statements to a P.O. Box
- Using business funds to cover personal obligations
- Depositing business income into your business bank account
- Using personal funds to cover business obligations
- Paying business expenses from your business bank account
- Paying personal expenses from your personal bank account



Had Ryan set up a separate business bank account at the start, he would have stopped the buyer from piercing the corporate veil. After all, he followed many of the other corporate formalities. But because he didn’t have a business bank account, he was personally liable to the buyer.


Do not make the same mistake Ryan made. Have two separate bank accounts and use them as such.

Checkbook IRA

Checkbook IRA – Checkbook LLC

Whatever You Call It –There’s Trouble Ahead

A recent case has shed light on one of the riskiest retirement plan strategies put forth by promoters. In McNulty v. Commissioner (157 T.C. 10) a U.S. Tax Court brought clarity to the scheme of using self-directed IRAs for personal investments. While the rules are strict, they had become lax and unenforced in recent years. The McNulty case brings the requirements back into line, and serves as a warning of what may come.

If you have a checkbook IRA or LLC you may want to speak with your lawyer immediately.

The facts in McNulty are fairly common. We have seen such promoters at investment conferences for years.

In August 2015 Mrs. McNulty purchased services from Check Book IRA, LLC (Check Book), through its website, that included assistance in establishing a self-directed IRA and forming an LLC to which she would transfer IRA funds though purchases of membership interests and then purchase American Eagle (AE) gold coins using IRA funds. During 2015 Check Book’s website advertised that an LLC owned by an IRA could invest in AE coins and IRA owners could hold the coins at their homes without tax consequences or penalties so long as the coins were “titled” to an LLC.

So, Mrs. McNulty used the company to set up Green Hill Holdings, LLC (Green Hill) to own the coins. Green Hill was then owned by her IRA.

There were a few problems with this. First, an IRA trust must be administrated by an independent trustee, not the beneficiary of the retirement assets. The trustee is responsible for storing the coins in an adequate vault. In this case, Mrs. McNulty, following the promoter’s advice, took personal possession of the coins herself and held them in her own safe at home.

McNulty and the IRS made numerous arguments and counterarguments as to why the whole chain of events was either appropriate or amiss. The court could have decided the case on a number of issues but chose just one — this is important and we will come back to it.

The Tax Court noted that an owner of a self-directed IRA is entitled to direct how her IRA assets are invested without forfeiting the tax benefits of an IRA, and that a self-directed IRA is permitted to invest in a single-member LLC.

However, IRA owners cannot have unfettered command over the IRA assets without tax consequences. The Tax Court stated that it was on the basis of Mrs. McNulty’s control over the American Eagle coins that she had taxable IRA distributions.

A qualified custodian or trustee is required to be responsible for the management and disposition of property held in a self-directed IRA. A custodian is required to maintain custody of the IRA assets, maintain the required records, and process transactions that involve IRA assets.

The presence of such a fiduciary is fundamentally important to the statutory scheme of IRAs, which is intended to encourage retirement saving and to protect those savings for retirement.

The Tax Court emphasized that independent oversight by a third-party fiduciary to track and monitor investment activities is one of the key aspects of the statutory scheme; that when coins or bullion are in the physical possession of the IRA owner (in whatever capacity the owner may be acting), there is no independent oversight was clearly inconsistent with the statutory scheme; and that personal control over the IRA assets by the IRA owner was against the very nature of an IRA.

The Tax Court concluded Mrs. McNulty had complete, unfettered control over the American Eagle coins; that she was free to use them in any way she chose; and that this was true irrespective of Green Hill’s purported ownership of the American Eagle coins and her status as Green Hill’s manager.

Once Mrs. McNulty received the American Eagle coins, there were no limitations or restrictions on her use of the coins, even though she asserted that she did not use them. While an IRA owner may act as a conduit or agent of the IRA assets, an owner of a self-directed IRA may not take actual and unfettered possession of the IRA assets. It is a basic axiom of tax law that taxpayers have income when they exercise complete dominion over it. Constructive receipt occurs where funds are subject to the taxpayer’s unfettered command and she is free to enjoy them as she sees fit.

The Tax Court concluded that Mrs. McNulty’s possession of the American Eagle coins was a taxable distribution. Accordingly, the value of the coins was includible in her gross income. The Tax Court noted that the McNultys’ arguments to the contrary would make permissible a situation that was ripe for abuse and that would undermine the fiduciary requirements of the act. Mrs. McNulty took position of the American Eagle coins and had complete control over them. Accordingly, she had taxable distributions from her IRA in excess of $300,000 — a painful financial mistake.

We have long warned about the risks of the check book scheme. In my 2015 book Finance Your Own Business the hazards were enumerated with the conclusion being “The safer course is to stay away from Checkbook IRAs.”

Interestingly, some promoters claim that the McNulty case is limited to situations in which gold coins were taken into personal possession. But that narrow view misreads the whole case. (Indeed, if they argue otherwise ask for a legal opinion letter on the viability of the Checkbook LLC.)

Remember when we said the court chose just one issue as a discussion point? The court mentioned numerous prohibited transactions (rule violations) and problems with the Checkbook scheme. But it focused on just the physical possession of the coins in this specific case.

The court may be doing everyone else using a Checkbook IRA a huge favor. The court may be signaling that future limitations on the scheme are coming. The court may be giving everyone a head’s up that its time to change your Checkbook IRA structure.

Be sure to talk to your own attorney about this. But here is a scenario to consider: Let’s say you are the manager of the LLC that controls your IRA investments. As such, you have management control over your IRA assets. You are keenly aware that the court in the McNulty case stated: “Personal control over the IRA assets by the IRA owner is against the very nature of an IRA.”

So to clean things up you need to step aside as manager of the Checkbook LLC. You appoint your CPA or attorney or other fiduciary as the manager so that you no longer have any personal control over your retirement assets.

If the IRS ever later questions you on such a move you tell the truth. You had initially been led to believe that the Checkbook IRA scheme was acceptable. But then you learned of the McNulty case. And in an attempt to follow IRS guidance you appointed a new, non-related fiduciary to serve as the LLC manager overseeing your personal IRA investments. You have made a good faith effort to be compliant with their rules in light of new information. Instead of doing nothing, by taking prompt corrective action you are in a much better position to ask for forgiveness.

The McNulty case is not the only challenge to the Checkbook LLC. Proposed legislation in Congress also seeks to crack down on IRA abuses. Talk to your professionals now to stay ahead of what is coming.  

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If you fail to secure such protection, anyone can start using your ideas, and in some cases they may demand that you stop using what they now claim is their trademark.

When you have secured the rights to your trademark, it is an asset that increases in value and can be sold or licensed to others. Therefore, registering a federal trademark is an essential component to any business and wealth building strategist.

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